The possibility of a tax audit can strike fear into the hearts of even the most seasoned contractors. Whether records are meticulously kept in computer files or gathered in an office drawer, there’s always uncertainty about whether enough documentation has been collected to satiate the IRS. Luckily, working regularly with a tax professional will increase your understanding of the financial state of your contracting business and decrease the likelihood of facing an audit.
There are factors that will make a contractor more susceptible to an audit, most of which lie in the deduction to income ratio, some of which have no determining factor and others that are noticed because of specific “red flag” deductions. Being aware of the factors that increase a chance for an audit and taking proper precautions to lower those chances will ease the burden during business and personal tax filings this year.
The IRS compares individual income deductions to the average for that of their tax bracket. If a taxpayer’s deductions fall outside the “normal” range for his or her income levels, the risk of an audit increases.
The deductions measured by the IRS include medical, tax, mortgage interest, and charity, and the monetary value for each are compared to the filer’s adjusted gross income (AGI), which is income minus specific deductions. The average deductions for a taxpayer with an AGI of $50,000 to $100,000 is $7,000 for medical, $6,000 for property and state income taxes, $9,000 for mortgage interest, and $3,000 for charity.
As income increases, the average amount of a deduction increases as well. For an individual whose earnings fall between $100,000 and $200,000, the deduction averages are $10,000 for medical, $11,000 for property and state income taxes, $12,000 for mortgage interest, and $4,000 for charity. If individual deductions fall outside this range, it is a red flag for the IRS and the likelihood of becoming a target for an audit increases.
THE LUCK OF THE DRAW
Not all audits are red flagged because of deduction thresholds. There is also the “luck of the draw” factor. There is no way to predict if an individual will be chosen for an audit this way, but as with deductions, it all comes down to the AGI. Each income level has a different probability of being picked for an audit, and as with most audit-related expenses, the higher the AGI, the higher the probability.
For taxpayers with an AGI below $200,000 there is only a one percent chance of being chosen for an audit. If income falls between $500,000 and $1 million, there is a 4 percent chance of being targeted. As wages increase, so does the percentage. Income levels of $1 million to $5 million have a 9 percent chance, the chance with earnings of $5 million to $10 million rises to 18 percent, and those who make more than $10 million face a 27 percent risk of an audit.
S CORPORATIONS ARE THE WAY TO GO
In the eyes of the IRS, not all businesses are created equal. There are different tax rules for different types of corporations. These are most frequently found in the categorization of C corporations and S corporations. Although both are publicly owned, a contractor’s business that is filed under an S corporation is not only allowed additional tax breaks, but also has a much smaller risk of getting audited by the IRS. This is because a larger liability is placed on the shareholders of S corporations and business losses don’t fall exclusively on the shoulders of the business owner.
C corporations have a 4 to 5 percent chance of being targeted with an audit, compared to the one half of one percent chance that S corporations enjoy. Consider changing the status of a C corporation to an S corporation to reduce the chances of an audit.
THE RED FLAGS
There are a number of red flag deductions that, even if other deductions are in line with AGI averages, may flag a business for an audit. The deductions are often business related, and difficult to keep records on. These include:
Claiming a home office. In the past, home office deductions have drastically increased the odds of being targeted for an audit. This year, however, the IRS has implemented a new simplified option for claiming home office deductions. The option—which allows for a $5 per square foot deduction up to 300 square feet, at a maximum of $1500—will greatly reduce the chances of being chosen for an audit.
Auto expenses. Many contractors driving to different sites will claim auto expenses as deductions, but they are not considered 100 percent deductible by the IRS. Travel to and from home is considered personal use unless home and work are the same.
Meal and entertainment deductions. In order to prove that these expenses are legitimate business deductions, meticulous schedule, and receipt records must be kept. During an IRS audit, an agent will expect to be provided with documentation from meetings as far back as 3 years prior. In addition to any online calendar appointments that are set up, it is also recommended to keep print records.
Audits are not something any business owner, contractor, or individual ever hopes to face, but if the advice above is followed, it should ease the process. Work closely with your tax professional and most importantly, record all expenses and revenue. Keeping the company’s CPA updated with accurate deduction and profit information will simplify the tax process and help protect the business if an audit should ever occur. ■
For More Information:
Bradford L. Hall, CPA is the managing director at Hall & Company, CPAs, an accounting, tax and financial services firm in Orange County, California. Bradford has more than 30 years of experience in public accounting and is actively involved in all aspects of taxation, auditing, and business planning. Bradford’s core strengths as an Irvine CPA are in the areas of strategic tax planning for high net worth individuals, including corporate owners and executives, closely held corporations, partnerships, LLCs, and trusts. To contact Bradford directly, call 949.910.4255, or email firstname.lastname@example.org.
Modern Contractor Solutions, March 2014
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